Matching Discretionary Income Streams to Tax Brackets

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Cyclesafe
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Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Wed Feb 06, 2019 12:01 am

I'm struggling to properly match numerous controllable (in the longer term for sure) income streams to sequentially progressive tax brackets.

It is important (I think) to determine, for example, what marginal tax rate one is converting increasing amounts of a t-IRA to a Roth. In future years, the comparison of similarly determined marginal tax rate(s) for RMD's will determine whether the original conversion was worthwhile - or not.

Taxable income from basic income sources like interest on emergency funds, taxable social security income, and perhaps pensions might fill up deductions/exemptions and the lowest income tax tiers. Maybe interest and dividends from taxable investments fill the middle. Or would a conversion? And then where would RMD's fit in? What sources of income deserve to be charged the full real marginal rate, taking into account exclusions, phase outs, ACA subsidies, IRMAA penalties etc. etc.?

In general, the conversation here seems to indicate that the maximum real marginal tax rate is used for all of these, but I think that this approach would inhibit an investor from sometimes making what would otherwise be considered a correct move.

Or is this some kind of mental accounting?

Silk McCue
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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Silk McCue » Wed Feb 06, 2019 8:31 am

Cyclesafe wrote:
Wed Feb 06, 2019 12:01 am
In general, the conversation here seems to indicate that the maximum real marginal tax rate is used for all of these, but I think that this approach would inhibit an investor from sometimes making what would otherwise be considered a correct move.
I don't think that folks that are serious about tax planning and income required/desired in retirement apply the maximum real marginal rate for all sources of income. I think that the numerous posts I have seen here regarding marginal rates does so assuming that a reasonable analysis has been done allowing you to make sound decisions regarding the marginal rate on the next dollar taken/earned.

The key for me is to properly account for all of the taxable income sources and to assess the ability to make decisions that can affect/reduce the taxation of those items. Not too much that can be done about a pension (check), analyzing taxable account throwing off unnecessary income and capital gains (check), dividends and capital gains having favorable tax treatment until they don't (check), managing future RMDs via Roth conversions prior to SS in order to limit bumping the next dollar taken causing SS to be taxed at 50% or 85% on that dollar. Once you have taken care of optimizing all sources of income apart from RMDs you will be faced with the potential impact of the RMDs and SS taxation. For many, not all, that is going to be the most important income factor that can be positively impacted by proper planning.

The Retiree Portfolio Model is an excellent tool for helping folks work through this.

Cheers

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by ralph124cf » Wed Feb 06, 2019 9:49 am

By age 70.5, most people seem to have very little controllable income.

If you are entitled to Social Security, you will be taking it. If you have a pension it has probably started. If you have purchased an annuity, either it has started or you are waiting for it to start, but either way it is not controllable. Your RMDs from IRAs and generally 401(k)s must be started unless you are still working for the 401(k) sponsor. I would consider this your base income for tax planning purposes, and would say that these sources should be lumped together and thought of as being taxed at your AVERAGE tax rate.

I see no way to REDUCE these sources of taxable income except QCDs, and, temporarily, QLACs.

You can INCREASE taxable income by taking more than the RMD or selling appreciated stock in your taxable account, and you can also increase spendable income by taking distributions from ROTH accounts. These sources of income should be considered as being taxed at your MARGINAL tax rate.

Ralph

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by corn18 » Wed Feb 06, 2019 10:19 am

I use the extended version of i-orp to help manage withdrawals, conversions and taxes (at least for planning them). Great little tool:

https://www.i-orp.com/bequest/extended.html

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Epsilon Delta » Wed Feb 06, 2019 12:29 pm

You are struggling with this because it is difficult problem.

The problem you would like to solve is a global optimization. Marginal rates are mostly about local optimizations.

Consider when you have two decisions: How much to convert to a Roth? When to take SS? When you choose the stacking rules you essential solve for them one at a time. This simplifies the problem, but may not find the best possible solution.

One way to find the best solution is to consider all possible combinations and compare them, but the number of combinations increases very rapidly, particularly as there are likely to be far more than two moving parts, such as how much to convert to a Roth each year for ten years.

But you should not despair. Usually you can intelligently pick a series of local optimization (roughly equivalent to picking the stacking order) that will get close and in any case is better than not bothering to think about it.

The one thing to watch is that if somebody who you trust asserts that a solution out in left field (i.e. a different stacking order) is better than the one you found you should not dismiss it just because it doesn't agree with your stacking order. But in this case you have two particular solutions (theirs and yours) and it is fairly easy to compare particular solutions.

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Thu Feb 07, 2019 7:32 am

Silk McCue wrote:
Wed Feb 06, 2019 8:31 am
The key for me is to properly account for all of the taxable income sources and to assess the ability to make decisions that can affect/reduce the taxation of those items. Not too much that can be done about a pension (check), analyzing taxable account throwing off unnecessary income and capital gains (check), dividends and capital gains having favorable tax treatment until they don't (check), managing future RMDs via Roth conversions prior to SS in order to limit bumping the next dollar taken causing SS to be taxed at 50% or 85% on that dollar. Once you have taken care of optimizing all sources of income apart from RMDs you will be faced with the potential impact of the RMDs and SS taxation. For many, not all, that is going to be the most important income factor that can be positively impacted by proper planning.

The Retiree Portfolio Model is an excellent tool for helping folks work through this.

Cheers
This is what I am wrestling with. My situation is unique in that I am also taking years to surrender a sizeable investment variable annuity (before I am too old to enjoy the recovered basis) along with balancing Roth conversions / RMD's and the rest - all in an annually tax efficient manner over my assumed remaining life. I have force ranked sources of income, but when conversions (voluntary) rank later for marginal tax consideration and RMD's (involuntary) rank earlier, the results of my spreadsheet (assumes reversion to 2017 tax rates and 2017 brackets adjusted for chained CPI in 2026 and beyond) show alarmingly lessened value of conversions in early years. And testing reasonable small deviations to my assumptions show wildly divergent results.

Many posters maintain that conversions are a non-brainer. I'm thinking that unless one has a legacy interest (I don't) the decision(s) is(are) anything but. "Tax diversification" resists quantification.

BTW, I am hesitant to use other people's models as I don't have access to the numerous assumptions buried within their algorithms.
ralph124cf wrote:
Wed Feb 06, 2019 9:49 am
By age 70.5, most people seem to have very little controllable income.

If you are entitled to Social Security, you will be taking it. If you have a pension it has probably started. If you have purchased an annuity, either it has started or you are waiting for it to start, but either way it is not controllable. Your RMDs from IRAs and generally 401(k)s must be started unless you are still working for the 401(k) sponsor. I would consider this your base income for tax planning purposes, and would say that these sources should be lumped together and thought of as being taxed at your AVERAGE tax rate.

I see no way to REDUCE these sources of taxable income except QCDs, and, temporarily, QLACs.

You can INCREASE taxable income by taking more than the RMD or selling appreciated stock in your taxable account, and you can also increase spendable income by taking distributions from ROTH accounts. These sources of income should be considered as being taxed at your MARGINAL tax rate.

Ralph
I agree that the uncontrolables should be analyzed with one's average rate, but only using the average calculated before the controlables drive up the average up. Then there still is the issue of ranking the controlables...
corn18 wrote:
Wed Feb 06, 2019 10:19 am
I use the extended version of i-orp to help manage withdrawals, conversions and taxes (at least for planning them). Great little tool:

https://www.i-orp.com/bequest/extended.html
Again, I'm worried about the unknown embedded assumptions. One gets a number, but is the number useful or not?
Epsilon Delta wrote:
Wed Feb 06, 2019 12:29 pm
You are struggling with this because it is difficult problem.

The problem you would like to solve is a global optimization. Marginal rates are mostly about local optimizations.

Consider when you have two decisions: How much to convert to a Roth? When to take SS? When you choose the stacking rules you essential solve for them one at a time. This simplifies the problem, but may not find the best possible solution.

One way to find the best solution is to consider all possible combinations and compare them, but the number of combinations increases very rapidly, particularly as there are likely to be far more than two moving parts, such as how much to convert to a Roth each year for ten years.

But you should not despair. Usually you can intelligently pick a series of local optimization (roughly equivalent to picking the stacking order) that will get close and in any case is better than not bothering to think about it.

The one thing to watch is that if somebody who you trust asserts that a solution out in left field (i.e. a different stacking order) is better than the one you found you should not dismiss it just because it doesn't agree with your stacking order. But in this case you have two particular solutions (theirs and yours) and it is fairly easy to compare particular solutions.
"Stacking rules": a good way to think of this. And I agree, testing a finite number of different stacking orders in my spreadsheet is very easy. Thanks for this. In your stacking order where would you rank variable annuity surrenders, conversions, and RMD's?

This has been super helpful. Knowing that others are thinking this way is very encouraging. I thought I would hear crickets...

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Silk McCue » Thu Feb 07, 2019 7:48 am

Cyclesafe wrote:
Thu Feb 07, 2019 7:32 am
BTW, I am hesitant to use other people's models as I don't have access to the numerous assumptions buried within their algorithms.
Don't let your current lack of knowledge about "numerous assumptions" stop you from exploring tools that can increase your knowledge in an interactive way. RPM is written here by a member and there are threads on it and if you can't figure something out after doing due diligence you can post a question in an on-going thread. I-orp is fully documented regarding assumptions and the extended version takes into account SS reductions (or not) and implements the tax law as written including expiring provisions. The tools aren't end all be all solutions but are very useful in gaining a clearer picture than using a pencil or paper or a home built spreadsheet (although I have a highly complex spreadsheet that I built myself starting years ago).

Cheers

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Thu Feb 07, 2019 8:50 am

Silk McCue wrote:
Thu Feb 07, 2019 7:48 am
Cyclesafe wrote:
Thu Feb 07, 2019 7:32 am
BTW, I am hesitant to use other people's models as I don't have access to the numerous assumptions buried within their algorithms.
Don't let your current lack of knowledge about "numerous assumptions" stop you from exploring tools that can increase your knowledge in an interactive way. RPM is written here by a member and there are threads on it and if you can't figure something out after doing due diligence you can post a question in an on-going thread. I-orp is fully documented regarding assumptions and the extended version takes into account SS reductions (or not) and implements the tax law as written including expiring provisions. The tools aren't end all be all solutions but are very useful in gaining a clearer picture than using a pencil or paper or a home built spreadsheet (although I have a highly complex spreadsheet that I built myself starting years ago).

Cheers
I'll check them out. Thanks for the reminder to stay humble.

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by The Wizard » Thu Feb 07, 2019 10:13 am

Don't over complicate it.
Just look at your projected AGI for age 70 and beyond. That should include all likely income sources. Exclude Roth conversion beyond age 70.

Let's say that AGI is $120k.
And let's say 2018's AGI was around $90k at your age 65.
Well then, you want to be withdrawing more from tax deferred the next few years, to your checking account and/or Roth conversions, to get that AGI up around $115k and keep eventual RMDs from being even higher.

Two reasons vote in favor of doing slightly higher Roth conversions in some cases.
1) marginal tax rates are scheduled to revert back to previous rates after 2025 (24% ------> 28%)
2) married couple survivor could have higher tax rate...
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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Thu Feb 07, 2019 11:11 am

The Wizard wrote:
Thu Feb 07, 2019 10:13 am
Don't over complicate it.
Just look at your projected AGI for age 70 and beyond. That should include all likely income sources. Exclude Roth conversion beyond age 70.

Why exclude Roth conversions after age 70?

Let's say that AGI is $120k.
And let's say 2018's AGI was around $90k at your age 65.
Well then, you want to be withdrawing more from tax deferred the next few years, to your checking account and/or Roth conversions, to get that AGI up around $115k and keep eventual RMDs from being even higher.

Yes.

Two reasons vote in favor of doing slightly higher Roth conversions in some cases.
1) marginal tax rates are scheduled to revert back to previous rates after 2025 (24% ------> 28%)

The marginal 2019 AGI subject to 24%, prior to NIIT (calculated using MAGI adding in standard deductions), becomes 28%+3.8% (NIIT)=31.8% from 2025 through 2030, assuming brackets increase annually by the most recent chained CPI. The NIIT cutoff of $250k of MAGI is not indexed, so it comes into play earlier and earlier on a real basis.). Of course, with the old tax scheme, there will be more opportunities to itemize - limitless SALT deductions (in the absence of a reinstated AMT) comes to mind here. The devil is in the details.

2) married couple survivor could have higher tax rate...

I keep forgetting this one. The only uncertainty here is whether a couple becomes one singleton and most importantly when. A higher tax rate in that event is a certainty. Furthermore, Larry Swedlow tells us on page 197 in his new book Your Complete Guide to a Successful & Secure Retirement that only 29% of men and 15% of women over 50 "wish to remarry" and 29% of men and a full 54% of women "do not wish to remarry". Presumably, the remainder, 42% of men and 31% of women, are ambivalent. Prospects would not be good to reestablish MFJ status.

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by The Wizard » Thu Feb 07, 2019 11:41 am

I tend to think that Roth conversions after age 70 aren't especially worthwhile for a lot of single people:
You've just had a jump in AGI that has you paying high enough taxes.
Putting excess funds into VTSAX in taxable account is a decent deal vs converting more to Roth.
Older one gets, lesser time for benefit of additional funds in Roth to accrue.
Plus I'm not a really great fan of paying even more taxes before they are due...
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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Silk McCue » Thu Feb 07, 2019 11:47 am

The Wizard wrote:
Thu Feb 07, 2019 11:41 am
I tend to think that Roth conversions after age 70 aren't especially worthwhile for a lot of single people:
You've just had a jump in AGI that has you paying high enough taxes.
Putting excess funds into VTSAX in taxable account is a decent deal vs converting more to Roth.
Older one gets, lesser time for benefit of additional funds in Roth to accrue.
Plus I'm not a really great fan of paying even more taxes before they are due...
What are our thoughts on converting to Roth (once you have pushed fully through the SS Tax Hump and dropped down from say 40.7% back to 22%) up to the top of the 22% or even 24% bracket in order to reduce the amount being taxed the the 40.7% Hump bracket in subsequent years. Drawing down to taxable would be an option but will likely throw off dividends that will be taxable in the Hump ongoing.

Cheers

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Thu Feb 07, 2019 11:50 am

The Wizard wrote:
Thu Feb 07, 2019 11:41 am
I tend to think that Roth conversions after age 70 aren't especially worthwhile for a lot of single people:
You've just had a jump in AGI that has you paying high enough taxes.
Putting excess funds into VTSAX in taxable account is a decent deal vs converting more to Roth.
Older one gets, lesser time for benefit of additional funds in Roth to accrue.
Plus I'm not a really great fan of paying even more taxes before they are due...
For MFJ filers, limited Roth conversions are still a good idea. But regardless, I would try to put numbers to your assumptions. The answers may surprise you....

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Cyclesafe
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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Thu Feb 07, 2019 12:07 pm

Silk McCue wrote:
Thu Feb 07, 2019 11:47 am
The Wizard wrote:
Thu Feb 07, 2019 11:41 am
I tend to think that Roth conversions after age 70 aren't especially worthwhile for a lot of single people:
You've just had a jump in AGI that has you paying high enough taxes.
Putting excess funds into VTSAX in taxable account is a decent deal vs converting more to Roth.
Older one gets, lesser time for benefit of additional funds in Roth to accrue.
Plus I'm not a really great fan of paying even more taxes before they are due...
What are our thoughts on converting to Roth (once you have pushed fully through the SS Tax Hump and dropped down from say 40.7% back to 22%) up to the top of the 22% or even 24% bracket in order to reduce the amount being taxed the the 40.7% Hump bracket in subsequent years. Drawing down to taxable would be an option but will likely throw off dividends that will be taxable in the Hump ongoing.

Cheers
If "our" permits me to answer also, I would say that although federal taxes on qualified dividends are currently lower than for ordinary income, state taxes (Cali, for example, has no tax preference here) may still bite. Furthermore, one has to be pretty certain of the continuation for many years of this "favorable" tax treatment to sacrifice the potential for additional tax free space. Of course, one has to be certain that Roth stays "Roth" too. I am not as familiar with the SS tax hump zone, but I would suggest that for all the reasons stated above, continuing Roth conversions would be preferable to paying your marginal 40.7%. Especially since the entire Roth would be accessible tax free after the first Roth had been established 5 years....

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by bradpevans » Thu Feb 07, 2019 12:13 pm

Perhaps not "answers" but some thoughts and guidance.
None of this can be known for sure (i.e. market performance),
but its a place to start.

https://www.kitces.com/blog/tax-rate-eq ... nversions/

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Thu Feb 07, 2019 1:07 pm

This article gets at the subject, but as you say, offers no answers. Hence the need to grind away at the numbers.

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by MnD » Thu Feb 07, 2019 1:20 pm

All you need to know is when you and your partner are going to die, what the single and joint tax brackets will be many years or decades into the future, future market returns, what your kids tax brackets will be at the time and for many years after the 2nd of you passes away and numerous other details like what happens to IRMMA when the 10-year freeze on indexing is up in 2020 and if/when there is any SS or medicare legislation.

After that it's pretty easy to come up with optimum discretionary income streams against tax brackets now and down the road.

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Epsilon Delta » Thu Feb 07, 2019 2:10 pm

MnD wrote:
Thu Feb 07, 2019 1:20 pm
All you need to know is when you and your partner are going to die, what the single and joint tax brackets will be many years or decades into the future, future market returns, what your kids tax brackets will be at the time and for many years after the 2nd of you passes away and numerous other details like what happens to IRMMA when the 10-year freeze on indexing is up in 2020 and if/when there is any SS or medicare legislation.

After that it's pretty easy to come up with optimum discretionary income streams against tax brackets now and down the road.
That's a useful list of things we'd like to know and it is useful to note that we do no know them, but optimization does not require prescience. It's about making better decisions with the information at hand. Or sometimes finding any reasonable course of action with the information at hand.

To put it another way logic (or math or games theory) helps for chess, poker and buying a used car.

Optimization 101 -- Optimization of deterministic systems
Optimization 201 -- Optimization of probabilistic systems
Optimization 601 -- Optimization of non-parameterized systems

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by The Wizard » Thu Feb 07, 2019 2:39 pm

Silk McCue wrote:
Thu Feb 07, 2019 11:47 am
The Wizard wrote:
Thu Feb 07, 2019 11:41 am
I tend to think that Roth conversions after age 70 aren't especially worthwhile for a lot of single people:
You've just had a jump in AGI that has you paying high enough taxes.
Putting excess funds into VTSAX in taxable account is a decent deal vs converting more to Roth.
Older one gets, lesser time for benefit of additional funds in Roth to accrue.
Plus I'm not a really great fan of paying even more taxes before they are due...
What are our thoughts on converting to Roth (once you have pushed fully through the SS Tax Hump and dropped down from say 40.7% back to 22%) up to the top of the 22% or even 24% bracket in order to reduce the amount being taxed the the 40.7% Hump bracket in subsequent years. Drawing down to taxable would be an option but will likely throw off dividends that will be taxable in the Hump ongoing.

Cheers
I should clarify that I've always been well beyond the SS Hump Zone to this point in retirement, just receiving divorced spouse benefits for four years before starting personal benefit at age 70 next year.
So I've not done any real significant thinking about conversions for people in the Hump Zone...
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Re: Matching Discretionary Income Streams to Tax Brackets

Post by The Wizard » Thu Feb 07, 2019 2:46 pm

Cyclesafe wrote:
Thu Feb 07, 2019 11:50 am
The Wizard wrote:
Thu Feb 07, 2019 11:41 am
I tend to think that Roth conversions after age 70 aren't especially worthwhile for a lot of single people:
You've just had a jump in AGI that has you paying high enough taxes.
Putting excess funds into VTSAX in taxable account is a decent deal vs converting more to Roth.
Older one gets, lesser time for benefit of additional funds in Roth to accrue.
Plus I'm not a really great fan of paying even more taxes before they are due...
For MFJ filers, limited Roth conversions are still a good idea. But regardless, I would try to put numbers to your assumptions. The answers may surprise you....
I've been in a higher IRMAA tier since starting Medicare in 2015.
So once I hit 70, I may indeed Roth convert a few thousand dollars per year (as opposed to a few TENS of thousands now).
But I'd rather stay below the next higher IRMAA threshold.

This will get trickier/better soon as IRMAA thresholds start adjusting with inflation...
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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Sun Feb 10, 2019 9:41 am

MnD wrote:
Thu Feb 07, 2019 1:20 pm
All you need to know is when you and your partner are going to die, what the single and joint tax brackets will be many years or decades into the future, future market returns, what your kids tax brackets will be at the time and for many years after the 2nd of you passes away and numerous other details like what happens to IRMMA when the 10-year freeze on indexing is up in 2020 and if/when there is any SS or medicare legislation.

After that it's pretty easy to come up with optimum discretionary income streams against tax brackets now and down the road.
One must assume and quantify. Not to get an answer, but to better understand these interactions.

The decisions we make today, based on heuristics, cookie-cutter "rules of thumb", and lots of hand waving, will have a huge impact on us in the future.

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Cyclesafe » Sun Feb 10, 2019 9:57 am

Thanks to this discussion I have run the numbers for my situation. As stated elsewhere without evidence, converting now - on top of "involuntary" income - to a federal marginal rate of 22% is likely safe since post 2025 RMD's will be taken (in the old tax scheme, same stacking rules) at a maximum of 25% - prior to NIIT's $250k (MFJ) cutoff. Conversions to 24% are close to a wash, unless they a made with depressed t-IRA assets. (For once I am happy with VTIAX!.)

Variable annuity withdrawals will end at the top of the current 24% plus 3.8% NIIT bracket and after 2025 at the 33% plus 3.8% bracket. I'll get my basis back in 2035, hopefully in time to actually spend it. Yes, made a mistake with the VA - a very big one.

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Re: Matching Discretionary Income Streams to Tax Brackets

Post by Johnnie » Mon Feb 11, 2019 5:49 pm

I learned something interesting on this board recently about Roth conversions from a tIRA: Assuming the tax rate you're paying upon conversion is the same as the rate you'll be paying in the future for distributions from the tIRA, doing the conversion makes zero difference in tax liability.

To illustrate:
-- If I pay 22% to convert $10,000 of TSM to a Roth today, and the fund has doubled by the time I take it out of the Roth years hence, I'll have ($10,000k-$2200) * 2 = $15,600.

-- If I leave the $10k in the tIRA and TSM doubles, then when I take the distribution I'll get $20,000 - ($20,000*.22) = $15,600.

Most here will intuit that the goal in this conversion is to dodge RMDs, not "tax rate arbitrage."

It still gives me pause sometimes, but my antidote is to peek again at an RMD table. Plus, as long as there is no net cost, it is a very nice feeling to have all those extra dollars in a never-pay-another-dime-of-tax kind of place.
"I know nothing."

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